Japan: Monetary Action -- Necessary but Not Sufficient
Robert Alan Feldman (Tokyo)
A fascinating review of the Japan deflation. Hard to believe these "radical" ideas are actually showing up in popular press:
Much easier to read at the site; page down toward the bottom, it's there.
morganstanley.com
Japan: Monetary Action -- Necessary but Not Sufficient
Robert Alan Feldman (Tokyo)
Is it too late for Japan? The monetization is now complete along the yield curve. So is hyperinflation the next stop? Is Japan about to enter its Weimar Republic phase? Recently, questions of this sort have come
more frequently from investors, particularly foreign investors. Moreover, the
questions are coming from investors who have little direct interest in Japan. Examples include European investors who worry that Germany might be the next Japan, or that somewhere else might be the next Japan. In particular, criticism has been
targeted at the Fed and ECB for not moving aggressively enough in the
face of deflation potential. Japan is cited as the example of what not to do, for
example, in a paper by the Federal Reserve (“Preventing Deflation: Lessons fromJapan’s Experience in the 1990s,” by Ahearne et al., June
2002).
Although I agree that Japan has provided some examples of what other countries
should not do (just as have European and North American economies at times),
the contention that monetary policy was the key failure is, in my view, absurd.
Rather, the key omission was an aggressive approach to structural reform in
both financial and industrial sectors. To support this contention, let me
review some of the history of the 1990s.
Myth 1: Mieno Pricked the Bubble
One of the key myths is that Gov. Mieno
pricked the Japanese equity and land bubbles. While Mieno’s appointment clearly
changed expectations, the actual shift of monetary policy had begun long before
he took office. Indeed, Gov. Sumita (his predecessor)
knew that the equity/land bubble was a threat, and finally implemented the
first rate hike in May 1989 (75 bps), when the stock market was at 34,000 (up
by about 25% in the year to that hike). The stock market and the land market
ignored him. Gov. Sumita hiked again in October (50bps), when the stock market
was at 35,000. Again, the markets ignored him. Gov. Mieno took office in December, 1989, and hiked that month (50bps), when the
market was 38,000. This time, the equity market got the message, but the land
market did not. Land prices kept rising for another year. When industrial
production began to plateau and inflation showed its very first signs of
peaking in mid-1991, Mieno reversed course. His first cut was July 1991, taking
the discount rate from 6% to 5.5%. He cut rates twice more in 1991, for a
cumulative cut of 150bp. By year end, inflation was
down to 2.5%.
There was nothing slow about Mieno’s reaction
to the peak of inflation or the business cycle. This is especially true when
compared to the reaction of PM Miyazawa, who was reputed to be adept at
economic policy. Miyazawa refused to use active fiscal policy -- despite a
fiscal surplus of 3% of GDP -- until August 1992 -- fully 15 months AFTER Mieno
started to move. And when Miyazawa finally did
announce a fiscal support package, the equity market rebounded sharply. In this
case, the fault lay not with Mieno for not cutting early or enough, but rather
with Miyazawa for dawdling. And no one even discussed
the adequacy of the financial regulatory system at the time.
Myth 2: Faster Rate Cuts Could Have Saved Japan
Mieno is next accused of not cutting fast
enough thereafter, but this accusation is unsupported, in my view, for two
reasons. First, as the Fed report admitted, the economic forecasts of the time
did not consider deflation to be a real threat. In fact, if you use the Taylor rule logic of the Fed paper and insert a plausible
estimate of potential GDP from that time, his policies seem about right. (See
data below). The real short term rate (measured by the
unconditional call rate minus year-to-year change of the CPI, ex fresh food,
and adjusting for consumption tax changes) peaked at 5.3% in 3Q90, fell to 4.4%
a year later, but was smushed to only 2.1% in autumn 1992. Mieno did not overdo
it in 1990-92, and he cut real rates quite substantially in 1993-94.
Exhibit 1. Call Rate, Inflation, and Real Rates, 1989-93 Call
CPI
Chg
Real
Call Quarter
Rate
(%YY)
Rate
1989
1
4.18
0.9
3.3
2
4.76
1.2
3.6
3
5.35
1.5
3.9
4
6.20
1.7
4.6
1990
1
6.68
2.0
4.7
2
7.26
2.1
5.2
3
7.60
2.3
5.3
4
8.03
3.1
5.0
1991
1
8.15
3.1
5.0
2
8.10
3.0
5.1
3
7.35
3.0
4.4
4
6.52
2.3
4.2
1992
1
5.62
2.2
3.4
2
4.76
2.5
2.2
3
4.30
2.2
2.1
4
3.97
2.1
1.9
Source: Bank of Japan and Cabinet Office.
Second, and far more important, the financial
oversight authorities (at that time, the Ministry of Finance) were proving
themselves wholly naïve (and some commentators have attributed darker motives)
about the nature and extent of the bad loan problem. As bad loans piled up, the
authorities dragged their feet on accurate inspections, and relied on profit
taking of quickly vanishing gains on equity holdings to reassure the public
that the system was sound. Indeed, parts of the MoF and parts of the political
world were hoping that the BoJ would print enough money to bail the whole system out. The willingness of the BoJ to do the right
thing in the early 1990s gave hope to those managing regulatory policy that their own mistakes could be concealed. The public did not
buy the MoF’s sanguine view, and confidence in the financial system eroded.
Myth 3: Monetary Policy Can Work when the
Financial System Is Broken
By 1995, coordination between the BoJ and the
regulatory authorities became essential -- but was not to occur. This presented
the BoJ with a dilemma: If the regulatory authorities fail in their job, the
central bank becomes overloaded. It must handle both the moral hazard problem
(which requires high rates to squeeze out misallocated capital) and recession (which requires low rates to spur activity). This is a
dilemma that no one can solve. If a beneficial outcome for the economy
requires coordination, but the policy counterpart refuses to coordinate, is it
better for the central bank to give priority to the moral hazard issue or to
the cyclical issue? With the economy recovering in 1993-94, the question was left hanging as Gov. Mieno left office.
Mieno's successor, Gov. Matsushita, ducked
the problem, but it came back to haunt him and eventually cost him his job. Lax
oversight practices resulted in the collapse of several financial institutions
in 1997 and in entertainment scandals at both the Ministry of Finance and the
BoJ (in both cases, officials had accepted lavish entertainment in return for
favorable regulatory decisions). At this point, Gov. Hayami was
appointed, and had to clean up the mess. Unfortunately, his
counterparts, the financial regulatory authorities, remained in disarray. There
was a merry-go-round of changes of presiding minister, so that policy was not
stable. Public confidence fell even more. In addition, the regulatory
authorities were severely understaffed. To boot, the capital weakness of
financial institutions -- coupled with lax oversight -- encouraged the
misclassification of loans and lax definitions of capital.
The result was that banks were
forced, year after year, to admit that their initial assessments of NPLs
were wildly optimistic, and to take huge hits to their capital. Public injections
were required in 1999, in order to stave off under-capitalization of major
institutions. With the dramatic collapse in September 2001 of a retail company
that the authorities had allowed to be classified as
only moderately troubled, the public smelled deception again. Only after
September 2002, when the FSA accepted BoJ ideas on more credible loan
classification and IMF ideas on stricter definition of capital, was the
groundwork for successful monetary policy re-laid.
The Real Lesson: Effective Monetary Policy
Requires Effective Structural Policy
So we get back to the debate on what monetary policy
should do. For those who think that ending deflation simply means lowering
rates a lot and/or printing a lot of money, Japan’s experience should toll a warning bell. Base money
is up by 80% since 1997, while deflation has continued. Even monetarists in Japan now agree that the collapse of money velocity cannot stop without structural reform. Moreover, the Weimar experience suggests that rapid money printing will
not end the troubles of the Japanese economy. Even in less dramatic contexts,
no one has ever argued that high inflation improves resource allocation -- even
if it removes bank debt at the expense of creditors. On the contrary, capital
flight is the natural result of such an approach, in the wake of which both
confidence and real investment collapse.
I agree with my colleagues that it is necessary
for the ECB and the Fed to move aggressively, in order to prevent deflation.
Where my approach differs is on the question of whether monetary aggressiveness
is sufficient. Easy money was NOT sufficient for Japan to avoid deflation. Structural policies were
necessary too. In my view, the real lesson from Japan will be learned only when both Europeand the United
Statesfocus on the heavy, political issues of dealing with structural impediments to
resource re-allocation in their own economies.
By the way, I do NOT think that Japan is about to enter a Weimar Republic phase. Too much has progressed on the structural side,
particularly in the last few months, for this to be the most likely scenario. Japan, at least, appears to have learned the lesson of its
own recent history.
BC |
